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For Drug Companies, R&D Is Spelled C-R-O

Outsourcing, health-care style.

It hasn't been a good couple of months for employees at major drug companies. Pfizer(NYSE:PFE) announced that it's cutting roughly 19,500 jobs in connection with the acquisition of Wyeth(NYSE:WYE), and AstraZeneca announced cuts of 15,000 jobs by 2013, just to name a couple. The axe has come down, big time.

While the companies could pocket all the cash saved from not paying the extra salaries, investors should hope that they don't give up all the spending. Drug companies live and die by their pipeline, and if they stop spending on research and development, those pipelines will eventually dry up.

It seems more likely that the companies will continue to use at least some of that money and try to get more bang for their bucks by spending them on research and development done outside the company.

Outsourcing, health-care styleDrug companies can outsource practically everything these days. That includes all the stages of drug development, from making chemical libraries to preclinical tests in laboratories all the way through to phase 3 clinical trials. The advantage for the drugmakers is that this gives them a lot more flexibility. If a project needs to be trashed because it becomes clear the drug doesn't work, the pharmaceutical company isn't sitting around with employees waiting for the next project to appear.

Outsourcing companies like Parexel and Pharmaceutical Product Development, called clinical research organizations (CROs), can make money and deal with the changes that come from failed projects, because they have the flexibility to switch from one drug company's project to another. Other companies, such as China's WuXi PharmaTech, are able to perform tasks more cheaply than pharmaceutical companies can because they carry out preclinical research overseas, where scientists are often willing to work for less.

But even in the U.S., CROs can do what pharmaceutical companies do for cheaper. Last year, Eli Lilly(NYSE:LLY) sold one of its research sites to Covance(NYSE:CVD), and then set up a 10-year deal for the CRO to help it develop drugs. The CRO's money-saving business plan is benefiting both companies.

It's not just research and development that gets outsourced; there's even outsourcing available for marketing once the drugs get past the Food and Drug Administration. inVentiv Health(NASDAQ:VTIV), for example, offers marketing services to help drugmakers launch their drugs. Keeping employees in-house to work on the launch of a new drug once or twice a year may not be the best use of a drug company's resources. inVentive even has sales reps who will hock the drugs after the launch for as long as the company needs them. There's that flexibility again.

CROs in disguiseDevelopment-stage drugmakers have always been a vital part of pharma's R&D plans, but over the last few years, it seems things have been accelerating considerably. For instance, Exelixis(NASDAQ:EXEL) and Regulus Therapeutics have been able to sign licensing deals for drugs that are still in the laboratory and haven't even been tested in humans yet. And at last count, GlaxoSmithKline(NYSE:GSK) had partnerships with 16 different companies. Talk about outsourcing your drug discovery.

It seems to me that pharmaceutical companies are essentially turning into holding companies that license or purchase drug candidates, escort them through the regulatory maze, and produce and hock them once they get past the FDA.

I'm not sure that's such a bad business model. The pharmaceutical companies get to use their regulatory and marketing knowhow and leave the rest to companies that can do it more efficiently and for less. It's a win-win situation that should give CROs and small drug developers a boost in the coming years.

Fool contributorBrian Orelli, Ph.D., wonders whether there's a market for bumper stickers that read, "CROs do it for less." He doesn't own shares of any company mentioned in this article. We tried to put the Fool's entiredisclosure policyon a bumper sticker, but it wouldn't fit.